Wave analysis is nothing else but the “wave theory”
of Ralph Nelson Elliot. The basic of this theory is an assumption that
the psychology of social behavior may be represented in the form of
models.
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Elliot used stock market as an input data. He noticed that the
trajectory of the price movement shows some structured picture of the
balance between supply and demand. On the basis of this, Elliot founded a
unique method of market analysis with the possibility of using it on
the Forex currency market. He identified more than ten graphical models
of the price movement which he later called “waves” hence the name “wave
analysis” occurred.
The main principal of “wave analysis” says that the asset price movement
consists of 5 waves after which the whole model is changed by another
one which consists of 3 waves moving in the opposite direction.
Waves indicated by the figures were dubbed "cardinal" by Elliot and
later they were called "impulse", as for the waves indicated by the
characters they were dubbed corrective waves or "triples". Wave "2" is a
corrective wave to the impulse wave "1", accordingly wave "4" is a
correction to the wave "3". a-b-c is a correction to the whole sequence
of the model 1-2-3-4-5. On the bigger time interval the whole sequence
1-2-3-4-5 forms one wave of the interval and creates impulse waves
"1","3" or "5". Accordingly, the sequence a-b-c forms the corrective
waves "2" and "4" of the bigger time interval.
Elliot formulated three main rules of the wave analysis:
- The amplitude of the wave "2" can not be more than the one of the first waves and it can not break its start point;
- The wave "3" can not be the smallest in the amplitude but it can be not the longest one;
- The wave "4" can not break the top of the first wave.
The price movement against the current direction is called correction.
In the wave analysis these are “corrective waves”. Elliot formulated the
main rule for such movements which says that corrective waves can not
be five wave models unlike to the impulsive waves. Therefore, five-wave
price movement against the wave of the bigger time interval can not be
completed correction, but only the part of it.
Corrective models of the price movement may look differently. It can be
both sharp jerk against the existing trend and a long time, stretched
price movement.
All other models of the price behavior and also their rotation and the
place of their appearance derive from the Elliot's basic model and
include a lot of various combinations.
Wave analysis is quite powerful instrument which helps to make good
profit by working on the financial markets such as Forex. But it is not
so easy. The main disadvantage of the theory is that you need to spend a
lot of time getting invaluable experience and adjusting the common
trading strategy for yourself in order to apply it in real trading
successfully and to make a decent profit.
This method of analyzing the price movement is usually the hardest to
learn by the newbies. That's why if you want to use wave theory as the
basics for your trading strategy be ready to work hard for a long period
of time. As a result you will get a comprehensive understanding of the
current situation on the market, you will begin to understand the logic
of the price movement and will constantly increase your deposit with
the passage of time.